Measuring Profitability

Question 1

Ratio Analysis

Answer 1

Ratio analysis allows for a more meaningful interpretation of published accounts by comparing one figure with another

It allows for both interfirm and intrafirm comparison

Ratios will be used by internal stakeholders such as managers and employees as well as external stakeholders such as investors and creditors

Question 2

Interfirm

Answer 2

Interfirm is between different firms e.g. comparing the performances

Question 3

Intrafirm

Answer 3

Intrafirm is within the firm e.g. comparing this year’s results with last years

Question 4

Stakeholder

Answer 4

A stakeholder is anyone with an interest in the activities of a business, whether directly or indirectly involved

Question 5

Profitability

Answer 5

Profitability is a measure of the profit of a firm in relation to another factor

It allows for a more comprehensive assessment of the performance of a firm by comparing one figure to another

Question 6

The Profitability Ratios

Answer 6

The four profitability ratios are:

• Gross Profit Margin
• Mark-up
• Net Profit Margin
• Return On Capital Employed (ROCE)

Question 7

Gross Profit Margin

Answer 7

This ratio looks at gross profit as a percentage of revenue (sales turnover)

It shows how much of every £1 made in sales is left as gross profit after the cost of goods sold has been deducted

E.g. A gross profit of 88% means for every £1 sales made 88p is left as gross profit

If gross profit margin falls from one year to the next the firm may reduce the cost of its purchases e.g. cheaper supplier

Question 8

Gross Profit Margin Formula

Answer 8

Gross Profit Margin = Gross Profit / Revenue x 100

Question 9

Mark-up

Answer 9

This ratio looks at profit as a percentage of cost of sales

It shows what percentage of cost of sales is added to reach selling price

E.g. a mark-up of 25% means that if the cost of raw materials to produce a good were £1 it has to been sold for £1.25

Question 10

Mark-up Formula

Answer 10

Mark-up = Gross Profit / Cost Of Sales x 100

Question 11

Net Profit Margin

Answer 11

This ratio looks at net profit as a percentage of revenue (sales turnover)

It shows for every £1 made in sales how much is left as net profit after all expenses have been deducted

A net profit of 31% means that for every £1 of sales made 31p is left as net profit

If net profit margin falls from one year to the next a firm will reduce its expenses e.g. move to a cheaper premises

Question 12

Net Profit Margin Formula

Answer 12

Net Profit Margin = Net Profit / Revenue x 100

Question 13

Return On Capital Employed (ROCE)

Answer 13

This ratio shows the percentage return a business is achieving from the capital (money) being used to generate that return

It shows for every £1 invested in the business in owners’ capital or retained profit what percent is being generated in profit

A ROCE of 5% means that for every £1 tied up in the business, 5p is being generated in net profit

Investors will often compare ROCE to the interest rate being offered in a bank or building society to see if their investment is working effectively for them in generating a return

Question 14

Return On Capital Employed (ROCE) Formula

Answer 14

ROCE = Net Profit Before Interest & Tax / Capital Employed x 100